IS PRESENT U.S. MONETARY TIGHTENING BEING ABANDONED?

The article published in this column on May 7, 2019 showed that the whole world is watching the US monetary policy because the US Dollar is the widely used global reserve currency. The article also highlighted that the model of the monetary policy implemented by the US Federal Reserve System (Fed) at present is primarily the regulation of the daily liquidity in the banking sector to control financial conditions, i.e., interest rates and credit, desirable for the control of inflation symmetrically around 2%.

Present US Monetary Policy Model

Key Monetary Policy Tools

The fed funds rate target and open market operation (OMO-buying and selling of securities by the Fed) are the major policy tools. The OMO is the mechanism used to regulate the liquidity or funds in the banking sector in order to control fed funds rates (inter-bank overnight interest rates) within the rate targets. Therefore, the Fed attempts to control both the price (interest rate) and quantity (liquidity) in the inter-bank market.

Inflation Control

The Fed believes that this price-quantity control will have corresponding impact across the financial sector which will influence all economic activities. The overall economic impact will eventually be the change in commodity prices or inflation over the time, i.e., tight monetary policy to reduce inflation and relaxed monetary policy to raise inflation. Therefore, the Fed takes policy decisions to drive annual inflation around a target/goal set by the Fed in order to preserve the purchasing power of the US Dollar. As such, the Fed has both goal-independence and tool-independence.

Policy Cycle

The US monetary policy in the recent past is seen in two distinct periods, the period of policy relaxation from August 2007 to December 2016 and the period of policy tightening thereafter. Such policy cycles are generally seen in almost all countries. This article covers the US policy tightening period.

Background for Tightening Ultra Relaxed Monetary Policy

The present policy tightening phase commenced to reverse the ultra-relaxed policy that was implemented during the period from August 2007 for the recovery from the financial crisis 2007/09 in the US and Europe. The Fed cut fed funds rate target to 0-0.25% by December 2008 from 5.25% in August 2007 to bring down interest rates close to zero so that credit and spending could be raised significantly to stimulate growth and employment.

To keep interest rates close to zero, the Fed had to print an excessive amount of money through purchase of securities (OMO) known as quantitative easing. As a result, the Fed balance sheet/assets reported a historic increase by four times or US$ 3,583 bn between 2007 and 2014 (i.e., from US$ 915 bn in 2007 to US$ 4,498 bn in 2014). This would have created a phenomenal amount of new liquidity in the world through credit/money multiplier (around 4).

The forward guidance given by the Fed for this monetary policy was to raise inflation to 2% (from deflation) and to reduce unemployment to 6% (from 10%).

Policy Tightening Phase

When the economy recovered to strong levels with inflation around 2%, unemployment falling below 5% and growth rising to 3%-4%, the Fed started to tighten the monetary policy. The idea was to prevent inflation rising above 2% in future due to excessive liquidity prevailing in the economy. The Fed envisages to pick neutral/long-term levels of interest rates and unemployment that are expected to keep the economy stable.

The Fed communicated the tightening signal in two stages. First, it terminated the monthly asset purchase programme (QE) in October 2014. However, all maturity proceeds of assets held by the Fed under QE were reinvested to prevent a drastic reduction in market liquidity. Second, the Fed raised fed funds rate target to 0.25%-0.50% in December 2015 (after maintaining it at 0-0.25% for 7 years). Thereafter, the Fed started faster tightening since December 2016.

Raising Fed Funds Rate Target

The Fed raised the fed funds rate target eight times by 0.25% each during the period from December 2016 to December 2018. The total increase is 2% from 0.25%-0.50% to 2.25%-2.50% (See Chart 1). In December 2018, the Fed speculated another three interest rate hikes (by 0.75%) in 2019.

The Fed Chairman Jeromy Powell made a comment at a forum on October 2, 2018 that “Interest rates are still accommodative. We are gradually moving to a place where they are neutral, but not that we are restraining the economy. We may go pass the neutral, but we are a long away from the neutral at this point, probably.” At this time, fed funds rate target was 2.00%-2.25%.

The Fed did not provide any forecast for neutral interest rates, but clarified neutral interest rates as interest rates that neither restrain nor overheat the economy. Based on interest rate forecasts of the Fed, markets speculated neutral interest rates (fed funds rates) to be around 3.0% to 3.5%.

Reducing Money Printing

While undertaking the OMO at reducing phase to control fed funds rates at higher targets, the Fed reduced its balance sheet by about US$ 523 bn from December 2014 to March 2019 by absorbing money permanently from the economy. The reduction from December 2017 to March 2019 alone was US$ 475 bn (See Chart 2).

Reinvestments of maturity proceeds of Fed’s assets also were gradually reduced, i.e., from all monthly maturity proceeds and interest in the month of October 2014 to maturity proceeds in excess of US$ 30 bn in respect of Treasury securities and US$ 20 bn in private securities in the month of March 2019.

Policy Spillovers

The US monetary policy decisions immediately cause considerable spillovers across financial conditions in both the US and the rest of the world. They affect real economic activities, i.e., resource mobilization, production, employment, wages, spending and prices/inflation, over a period of time. The monetary tightening is expected to tighten financial conditions and slowdown inflation.

Spillovers in the US Economy

Accordingly, the faster tightening led to raise interest rates and decelerate liquidity and credit flows. As compared to interest rates around zero kept for about 7 years, the increase in interest rates by 2% in just two years (2017-2018) was considerable for the US. As a result, short-term interest rates and yield rates in all US financial markets rose sharply while securities prices declined.

The US yield curve became flattening as short-term yields rose faster than long-term yields where the yield for 10 years fell 6 basis points below 3 months yield first time since 2007 in March 2019. In addition, financial markets underwent considerable volatilities and sell-offs from time to time.

However, the US economy showed mixed results. Unemployment steadily declined from 4.7% in January 2017 to 49-year low 3.6% in April 2019 while new employment rose on records. The GDP growth slowed down from 4.2% in second quarter 2018 to 3.2% in first quarter 2019. Annual inflation which reached 2% target in 2016-18 started falling away below 2%, i.e., 1.5% in March 2019. Therefore, analysts including the President Donald Trump and his economic team started heavily criticizing the Fed’s policy tightening when both inflation and unemployment were falling and that the Fed’s economic models were outdated to track the real economy.

Global Spillovers

Emerging market economies started feeling the pinch by way of capital outflows in early 2018 although those central banks did not act timely. High interest rates along with US protectionist economic policies caused capital flows to the US resulting appreciation of the US Dollar and excessive depreciation of emerging market currencies. In fact, emerging world experienced currency turmoil since July 2018.

As a result, many economies confronted considerable crunches of foreign reserves, liquidity and credit which caused adverse effects on the growth. Currency depreciation led pressures on inflation in countries that widely depended on imports. As an immediate reaction, many central banks raised policy interest rates in the range of 0.5% to 10% to fight capital outflows and injected fresh liquidity by printing money to keep financing the economy. Some central banks even tightened controls of import credit and foreign exchange.

The global growth also started showing signals of slowdown since fourth quarter 2018 due to trade tensions between the US and China and frequent volatilities of financial markets and capital outflows.

Fed’s Response to Adverse Spillovers

In this background, the Fed on March 20, 2019 decided to pause interest rate hike and to provide some accommodative measures. Decisions to slow down the reduction/tapering of Fed balance sheet and to pause the tapering since September 2019 are to ease the financial conditions.

The Fed also changed its policy goal as to “sustain economic expansion” (with a strong job market and stable prices for the benefit of the American people) as against earlier communication of maximum employment and stable prices (inflation target of 2%). Therefore, the Fed now seems to prioritize the growth.

The new policy stance has brought some stability to both the US economy and emerging market economies. Therefore, in last two weeks, central banks who do not have major concerns over foreign reserve levels decided to cut policy interest rates.

Meantime, the second round of US tariffs hike from 10% to 25% announced last Friday on imports worth US$ 200 bn from China and plan for tariffs on additional US$ 300 bn of imports are likely to call for accommodative monetary policies in both the US and China to address possible adverse effects on growth. In retaliation, China also raised tariffs on U$ 60 bn worth imports, mainly agricultural products, from the US. The US proposed US$ 15 trillion of subsidy plan to support agriculture. The US stocks fell on Monday and wiped-out nearly US$ 600 bn of value.

In this background, some analysts predict even a rate cut by the Fed in the second half of 2019 and another three cuts later. The President Trump commented that the US economy would go up like a rocket if the Fed cuts interest rates by like 1% and resumes asset purchases/quantitative easing. Chinese central bank also will relax monetary policy and raise new funding at low cost to identified sectors of the economy to negate the price impact of new tariffs. Central banks in advanced market economies also will keep current relaxed policy stance, given the slowdown in global growth and further recovery needed.

In this background, it may not be unreasonable to predict a new phase of monetary accommodation in the US and the world. This would be a relief to emerging market economies. However, monetary policies are highly uncertain in present market-based models, despite policy forecasting models, as policy decisions are driven by theoretical thoughts, rather than credit delivery across economic sectors.

(The next article will cover the US monetary policy relaxation since 2007).

(The writer is a former Deputy Governor of the Central Bank and chairman and member of 6 Public Boards with nearly 35 years of public service. He authored 6 economics and financial/banking books and more than 60 published articles.). His latest Book “INNOVATING CENTRAL BANKS” covers a detailed part on the monetary policy.